Audit warned State Board of Administration about risky investments

SENTINEL EXCLUSIVE

TALLAHASSEE -- An internal audit conducted by the State Board of Administration last year red-flagged the agency for not adequately supervising risky investment decisions by its money managers.

The report foreshadowed problems that nearly wiped out a $27 billion local-government investment pool during a recent run that left some governments in Florida scrambling to cover payrolls and other bills.

In findings the agency has yet to answer nine months after receiving the report, the audit said the SBA:

*Lacked adequate risk-management reviews of whether managers were subjecting taxpayers' money to unnecessary risk, and senior management wasn't sufficiently involved in setting key investment goals. The investment fund unraveled in November when local government officials -- after questioning whether their money was invested in companies backing subprime mortgages -- panicked when they didn't get clear answers.

*Lacked "a formal process to evaluate and review the risks" of new types of investment vehicles, such as the mortgage-backed securities that provoked the run on the local-government fund. More than $2.7 billion of these securities bought by the SBA were down-rated last fall after a worldwide credit crunch prompted by the mortgage-market meltdown.

*Relied on too-few companies to handle investment trades. "Heavy concentration of trades with a few brokers may be exposing the SBA to unacceptable credit exposure," the audit said. One of the companies named, Lehman Brothers, sold the SBA 40 percent of the $2.75 billion in securities that have since been downgraded or defaulted.

Nine months after a final version of the audit was sent to SBA managers in March, the agency has yet to respond to the auditors' recommendations. In a Dec. 5 e-mail to SBA managers, chief internal auditor Flerida Rivera-Alsing asked for a response by tomorrow.

"I know you have a lot of 'stuff' to take care [of] so please let me know if a response by COB January 4 is doable," she wrote.

Kevin SigRist, the SBA's deputy director, said the agency hadn't put together a response but that some of the recommendations -- such as creating a risk-management committee that would advise the director -- were being implemented. Change, he added, takes time.

"We just have not gone through that whole process to pull that together," he said. "That's how the world works here."

Moved from secure to riskier

Squirreled away in a corporate-office complex across town from the Capitol, the 18 or so securities traders for the SBA were workhorses on Wall Street. Until last month, they managed more than $50 billion in securities investments, including about $27 billion deposited by 1,000 cities, counties, school boards and other governmental units. (The SBA's trustees have since stripped the agency of managing the pool and handed it off to BlackRock, a private manager.)

During an 18-month period in 2003 and 2004 -- the audit period -- those managers made more than 21,600 trades totaling $1.1 trillion in value.

The local-investment fund was intended to operate like a money-market fund, producing relatively low returns in exchange for instant access to cash. But during and since the audit period, the SBA money managers were moving away from secure -- but low-interest -- government securities to higher-returning -- but riskier -- investments in commercial paper.

Without referring to any specific investment decisions, the audit said that the SBA didn't have adequate, agency-wide risk-management reviews in place.

"Some risk management practices are being implemented in silos," it added, suggesting that individual SBA divisions were making decisions on their own.

For example, it said, SBA's senior management typically wasn't involved in deciding "benchmarks," or target measures of success, for various short-term investments. Instead, they were set by a lower-level investment officer.

It also found the agency didn't have "a formal process to evaluate and review the risks" of new types of investment vehicles.

In 2007, the short-term money managers made investment decisions that proved costly.

Beginning in January, they bought $2.75 billion in asset-backed commercial paper and "structured investment vehicles" issued by Countrywide Mortgage and other companies and investment partnerships in the subprime mortgage business.

Some of these pay interest of more than 6 percent, an unusually high return for the fund. But by August, these investments -- a kind of short-term IOU backed by thousands of individual mortgages -- began defaulting because of the worldwide credit crunch and were downgraded.

About one-third of those downgraded securities, $947 million worth, are in the local-government investment pool. Worse, all were bought in late July and early August -- months after the collapse of the subprime-mortgage industry became apparent.

"The question is, 'Was someone asleep at the switch?' " said Richard Leisner, a securities attorney with the Trenam Kemker law firm in Tampa.